If a court finds that a clause in a contract amounts to a "penalty clause" it will simply not be enforceable. This can cause real frustration for anyone expecting that a contract would be enforced on its own terms.
In two recent Irish cases, Sheehan v Breccia and Flynn v Breccia, the High Court considered the enforceability of certain standard loan conditions of Anglo Irish Bank. We take a look at the decisions of the High Court in those cases, decisions which will be of particular interest to lenders and loan purchasers but which also have a wider general interest.
Default Interest Clauses as Penalties
In the related Irish cases of Sheehan v Breccia and Flynn v Breccia, a key question was whether a lender was entitled to include surcharge interest in the amount required to redeem a loan. The High Court held that whilst the general conditions of the loan agreement contractually permitted surcharge interest following a default, in these cases it amounted to an unlawful penalty used to deter the borrower from breach of contract and was therefore unenforceable. The default interest clause provided:
"Any monies due by the Borrower to the Bank and for the time being unpaid will bare [sic] surcharge interest at the rate of 4% over the Facility Interest Rate or at the Bank's discretion at a rate equivalent to the aggregate of 4% over the Facility Interest Rate on the due date calculated on a daily basis from the due date to the date of actual payment after as well as before demand is made, any judgment obtained hereunder or the insolvency of the Borrower".
In finding that this constituted a penalty clause and was therefore unenforceable the High Court noted and was influenced by a number of factors including:
- that applying an additional surcharge rate of 4% would, on average, double the overall rate of interest charged during the default period;
- that the default interest clause was a blunt provision that took no account of the variables that could affect the amount of the lender's likely loss. As such, it was difficult to characterise application of the rate as a genuine pre-estimate of loss arising from default; and
- testimony of the expert witnesses that a bank or institution had never tried to charge default interest retrospectively in the manner that the defendant sought to do in this case and that the primary purpose of the default interest clause was to deter a breach by the borrower.
What Cavendish Decided
As outlined in our recent briefing, available here, in Cavendish Square Holding BV v El Makdessi the law on penalty clauses in England and Wales has recently been clarified by the UK Supreme Court. Before Cavendish, any clause in a contract governing the consequences of a breach needed to be based on a genuine preestimate of the innocent party's loss, in order to be enforceable. But Cavendish held that the true test of whether a clause is penal, is whether it imposes a detriment on the defaulting party which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the main purpose of the contract. So the UK Supreme Court effectively restored the "bigger picture" in the assessment of what constitutes a penalty in a commercial contract.
Cavendish in Ireland still Untested
In Sheehan v Breccia and Flynn v Breccia, the Irish High Court declined to take the opportunity to consider whether Cavendish should be adopted here. Whilst noting that "...arguments for applying a different test may be finely balanced, and there are attractions to the reasoning in Cavendish...." the Court ultimately declined to depart from the established Irish jurisprudence of the Irish High Court, considering it a matter for a higher court to decide.
The impact of Cavendish in Ireland therefore remains, as yet, untested but it has been indicated that appeals will be brought against the decisions of the High Court in both cases. This will give the Court of Appeal an opportunity to consider whether to follow the Cavendish approach.
The default interest clause at issue in both cases before the Irish High Court was a standard clause in bank loan documentation and therefore these cases do provide cause for thought as to how such clauses should be framed and applied.
However the level of the default rate and the attempt by the lender in these cases to apply the rate retrospectively can be considered unusual and, in themselves, penal in a manner that a more usual default interest rate and application might not be. It is also worth noting that the unenforceability of the default interest clause does not restrict the lender from recovering the principal and interest owing.
The prospect of the Court of Appeal having an opportunity to consider these cases will be welcome news both for lenders looking for certainty on the enforceability of default interest clauses and for other parties interested in clarity on the potential application of the principles in Cavendish in Ireland. In the meantime when agreeing or applying the terms of any contract, which have the potential to be interpreted as penal, the need to take appropriate advice is clear.